A letter of credit (LC) is a commitment by a bank, made at a buyer's request, to pay a seller once the seller presents documents that meet the letter's terms, such as a commercial invoice, bill of lading and inspection certificate. It replaces some of the buyer's credit risk with the bank's.
How it works in factoring
Letters of credit are common in international trade, where sellers may not know foreign buyers well. The bank examines the documents, not the goods, so precise paperwork is essential. Even small discrepancies can delay or block payment.
LCs connect to factoring and related financing in several ways:
- Purchase order financing: a PO financier may arrange an LC in favor of a supplier, so the supplier is confident it will be paid once it ships.
- Receivables backed by an LC: a seller expecting payment under an LC may be able to finance that right to payment, since the bank, not just the buyer, stands behind it.
- Standby letters of credit: these act as a backup guarantee, paying only if the buyer fails to pay, and can strengthen a factor's view of a customer.
In the US, letters of credit are governed by Article 5 of the Uniform Commercial Code, and many international LCs also follow industry rules published by the International Chamber of Commerce.
What to check
- Exactly which documents are required and their deadlines
- Whether the LC is confirmed by a bank in your country
- Whether your rights to proceeds can be assigned to a financier